Do investors overvalue firms with bloated balance sheets?

When cumulative net operating income (accounting value-added) outstrips cumulative free cash flow (cash value-added), subsequent earnings growth is weak. If investors with limited attention focus on accounting profitability, and neglect information about cash profitability, then net operating assets...

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Bibliographic Details
Published in:	Journal of accounting & economics 2004-12, Vol.38 (1), p.297-331
Main Authors:	Hirshleifer, David, Kewei Hou, Teoh, Siew Hong, Yinglei Zhang
Format:	Article
Language:	eng
Subjects:	Accounting Behavioral finance Capital market Capital markets Cash flow Correlation analysis Economic behaviour Expected returns Financial reporting Investors Limited attention Market efficiency Stock prices Studies Working capital
Online Access:	Get full text
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Summary:	When cumulative net operating income (accounting value-added) outstrips cumulative free cash flow (cash value-added), subsequent earnings growth is weak. If investors with limited attention focus on accounting profitability, and neglect information about cash profitability, then net operating assets, the cumulative difference between operating income and free cash flow, measures the extent to which reporting outcomes provoke over-optimism. During the 1964–2002 sample period, net operating assets scaled by total assets is a strong negative predictor of long-run stock returns. Predictability is robust with respect to an extensive set of controls and testing methods.
ISSN:	0165-4101 1879-1980